From the Desk of Ernie Zerenner: A 2018 Market Forecast
At the start of a new year, it is time to reflect on last year and changes to be made in the next year. This is the time of year to make New Year’s resolutions, consider changes to your will or beneficiaries, and investment portfolios. The new year brings the opportunity to make 365 changes and 260 change opportunities to your portfolio.
This weekend I tackled the last one, possible investment portfolio changes. These changes were based on several basic assumptions:
Historically we are overdue for a 10% level correction in stock prices.
With the influx of more money going into the economy from tax reform, repatriation of foreign earnings, and infrastructure rebuilding, there will be steady upward pressure on inflation. Running presently a 2%, considered to be ideal, to 3% and higher, which will lower Price/Earnings ratios.
We expect the above events to also create some market rotation into groups that were weak and out of sectors overvalued during the last years run up in stock prices.
Lofty valuations, increased inflation, and political/geopolitical tensions, will increase volatility and rotation of holdings into sectors like materials, energy, financial, and heath care. Some examples of potential holdings in these sectors are:
Materials – FCX, WPM, CF
Energy – SLB, GLOG, CVX, KMI
Financial – BAC, HQY
Health Care – VEEV, ALXN
Other – DIS, TIPS (cash)
Sectors to avoid would be bonds (unless very short-term), utilities, and telecom or other sectors generally purchased for dividends which may experience capital depreciation.
As cash is accumulated during the pruning process, it would be best stored in TIPS to provide some protection from erosion due to inflation. CVX and SLB have reasonable dividends and BAC, GLOG, WPM, and KMI have a growing dividend.
If you currently have unrealized gains in your positions but are worried about a correction, consider Locking in Your Gains with put insurance. Our Stock Insurance tool on PowerOptions will show which puts can lock in the highest percentage gains on your positions.
And, remember, if you are concerned about a market correction but want to remain active, consider the RadioActive Trading approach to limit your risks to single digits on any position – but keep the upside open.
It is year-end, and time to reflect on this year’s market activity. It certainly has been a strong up trending year for equities. And with all the very positive news currently, there is room for more gains in 2018. However, markets do not just go up forever. The markets are extended without a normal set back of 10% in some time. Is it time to be cautious?
While at the library this weekend, I looked through the Value Line Survey. They had a table of some key market and economic parameters for the present vs. historical highs and lows. Some that caught my attention are listed below:
Parameter Current Last Top Last Low
PE on VL stocks 20.3 19.6 14.3
Dividend Yield VL 1.9 2.0 4.0
Prime Rate 4.5 4.3 3.3
AAA Corp. Bonds 3.5 3.5 5.5
Short Interest/Vol 16.8 17.9 8.6
As you can see most of the parameters are in the range of the last top. On PowerOptions we have a Market Sentiment indicator, which reflects the current values of 13 broad based market indicators. Our recent readings have also seemed to indicate that the market may be over bought. But we have been over bought for some time now, and it is not clear when a correction will take place.
However, with the recent Federal tax cut enacted, there is an incentive for investors that wanted to take profits to wait for the new year to take advantage of the lower tax rates in 2018. Even though the economic environment is strong, there could be some selling pressure on stock prices that are extended. There is an old adage on Wall Street to buy the rumor and sell on the news. Now that the tax cut is a reality and the news is out, a correction could be at hand.
There are several approaches to remedy the stock price risk going into next year
Lighten up on stocks now before year-end, especially the weaker non-performers or losers. Raise some cash.
Here is Part 2 of our Stock, or Portfolio Insurance? Series: Selecting the Right Put
In this video we discuss which broad based ETF or Index Put to Select to Insure an overall portfolio.
Part 2 of Stock, or Portfolio Insurance - Selecting the Right Put - YouTube
In Part 1 you saw that using an SPY Put option (the 250, ATM strike) was better insurance on a portfolio over buying shares of an Inverse or Leveraged ETF.
However, was this the best strike selection?
What about lower strike, lower cost, Out of the Money Puts?
Wouldn’t puts with a higher delta, deeper In the Money perform better?
This video breaks down the costs, outcomes, pros and cons of the different strikes you can use to insure a portfolio. We also give you an outline of how to analyze which put might be best to insure your portfolio.
I hope you enjoy Part 2, and I look forward to your thoughts and comments!
This article is Part 1 of a series on evaluating the ways to add Portfolio Insurance if you are anticipating a market correction or market decline.
Most of us are probably in more Bullish positions, based on the last 12 months performance of the market. Every week new highs are being hit, and bullish stock and option traders have been doing well.
1 Year Performance SPY
Over the last 12 months, we have seen SPX (S&P 500 index) and SPY (S&P 500 ETF) gain over 17% (SEP 13th, 2016, SPY closed at $213.23 and is currently around $250.00).
1 Year Performance QQQ
During that same time period, NDX (NASDAQ 100 index) and QQQ move up 26% (SEP 14th, 2016, QQQ at $115.85 to about $146.00).
Sure, there were small hiccups here and there along the way, but the extended growth has led to many pundits, gurus and other stock prognosticators warning of a downturn and correction.
So the question many of you have been posing to us here at PowerOptions is:
“What is the best way to protect my portfolio against a -X% decline in the market?”
There are many ways to potentially hedge an investment portfolio, but this question is missing a few key factors. The most important of which is: ‘How much do you want to protect?’
A Look at the Most Basic Example.
Let’s say we have a $1,000,000 account, and for the sake of argument let’s say 80% of that is invested in SPY. This is not an advisable allocation of funds, but it would have an unrealized gain of 17% as we just saw.
So, $800,000 is invested in SPY. You are expecting a -10% market downturn, or a loss of -$80,000 on your investment. How can you protect against a -10% downturn?
Well, how much do you want to protect? This is one of the points that is missing from the initial question.
If you are comfortable only risking -5% of invested capital in a -10% decline, you could simply set a stop order (in this basic scenario) to close your shares of SPY if they drop -5% from the current value.
With SPY at $250.00, we would set a stop at $237.50, -$12.50 from the current price.
As long as that price is hit during the trading day, you would close out your position and only have a -5% loss from the current value – now a realized gain of $24.30 per share, or 11.8% if you had bought in and held from last year.
BUT! We all know the dangers of stop orders. It is really just a market order that tells your broker: Close my position if the stock / security is anywhere below that price at any time.
It is unlikely to happen with SPY, QQQ or a broad market ETF, but IF SPY gapped down -15% overnight – you don’t get to close the position at $237.50. Your order is triggered and you are closed out at whatever the market is offering…in this case, $212.50. You are now at a small loss on the total position from your original cost of $213.23. That is not what we want to see.
Again, that is not likely to happen in this case. But, what if you wanted to stay in the position and not be automatically closed out – and at the same time protect against an expected decline?
You would need an instrument, and the corresponding number of shares (or option contracts), that would gain $40,000 if you expected your portfolio to drop -$80,0000.
Common ways for Stock Traders to Insure a Portfolio:
We already talked about a Stop, which also includes a Trailing Stop. That is common protection #1.
But if we want control of our position and not leave it subject to a set number or the risk of the stop being violated, we would look at a different approach.
SPY is right around $250.00. If we invested $800,000 (or 80% of our portfolio) into shares of SPY we would purchase 3,200 shares.
And…yes, let’s throw out the logic that if we were expecting a -10% downturn in the market we would not be buying SPY today. Of course we wouldn’t be doing this. But, let’s work the numbers for a proper hedge…
What are the obvious hedges?
Set a Stop at -5% ($237.50) or a Trailing Stop. We just covered the pros and cons of a simple stop. It’s free, yes, but can be violated.
Sell out now, stay in Cash. This is always an advisable approach if you are considering a market downturn and you have hit your target for profit. Close out your bullish securities for gains or small losses, stay in cash and wait it out. But, we are looking for better solutions here, not the obvious.
Buy shares of the inverse ETF which will gain as the market falls. Inverse ETFs will move counter market, allowing investors to potentially hedge a portfolio.
ProShares Short S&P 500 (SH), an inverse ETF against SPY.
SH is currently trading at $32.45. If SPY declines -10%, SH would rise +10%, or roughly $3.25 to $35.70.
We need a $40,000 gain to counter the -$80,000 loss:
($40,000 needed / $3.25 gain per share (SH)) = 12,307
To counter half of the $80,000 loss on SPY we would need to purchase 12,307 shares of SH. This would be a total cost of $399,362.15.
Well, that doesn’t work. First, we only have $200,000 of free capital in our $1,000,000 account. Second, if the decline does not happen and the stock moves up, we are losing money on the $400,000 investment. Third, it is just not that efficient.
# of Shares
Price / Share
Value -10% decline
Gain / Loss
With this hedge we would have cut the loss in half to only -$40,000, or only -5% of our invested capital. This also represents only a -4% loss of the entire portfolio value. BUT, we would have to trade this on margin as we did not have the capital required to purchase that many shares of the inverse ETF.
We would want to use some kind of leverage to better hedge the position.
There are 2X and 3X Bear ETFs for SPY:
Pro Shares UltraShort S&P 500 (2X) ETF – SDS currently at $47.53
Direxion Daily S&P500 Bear 3X ETF – SPXS currently at $37.37
4. Buy shares of Leveraged, Inverse ETFs to hedge the position.
Percentage wise these securities will move twice or three times the amount of the movement in SPY.
A -10% decrease in SPY should result in a +20% increase in SDS, or a 30% increase in SPXS. So how many shares would be needed to counter half of our -$80,000 loss on investment?
With a -10% decrease, SDS should gain +20%, or +$9.50 to $57.03. To gain $40,000, we would need to purchase 4,210 shares of SDS ($40,000 needed / $9.50 gain per share = 4,210):
# of Shares
Price / Share
Value -10% decline
(SPY at $225.00; SDS at $57.03)
Gain / Loss
SDS (2X Bear)
So this is an easier pill to swallow, but it would still require an investment of just over $200,000, what is left in the portfolio, to cut the loss on SPY by 50%.
What about using more leverage with the 3X Bear ETF? SPXS should rise +30% with the decline. This would be a gain of $11.21 to $48.58.
# of Shares
Price / Share
Value -10% decline
(SPY at $225.00; SPXS at $48.58)
Gain / Loss
SPXS (3X Bear)
Now at least we can afford to purchase the number of shares required to lower our loss to only -5%, or -$40,000. But, aren’t there better methods of leverage? Hey, this is why we use options!
Option 5: Buy Puts directly on SPY.
Put options are extremely useful for insuring or protecting stock directly, or a portfolio. As the stock or market falls, the put options gain in value. There is a cost, but options give us leverage for both bullish gains, bearish gains, or protecting Bullish or Bearish portfolios.
If I wanted to hedge a position to counter 50% of the expected move, I might look at an At-the-Money put (close to the current stock price) with a Delta of 0.50 (would gain $0.50 for every -$1.00 drop in the stock price).
Unlike purchasing shares of an inverse and leveraged ETF as a hedge, the put option has a defined expiration date.
If I expected a -10% decline in the markets over the next two weeks, I may look to standard October expiration, 2017 (20-OCT – 30 days out in time):
Hedge: Purchase 20-OCT 250 strike puts at $1.95
One put contract represents 100 shares of the underlying security. The listed price of $1.95 / contract would actually cost $195.00 to purchase 1 contract.
If SPY fell to $225, say on October 13th, 2017 – the put option would be trading at close to Intrinsic Value (the amount that the put option is In-the-Money). We would expect the put option to be trading at a value of at least $25.00 per contract. So, how many put contracts would we need to buy to counter half of the projected $80,000 loss?
Original cost per contract = $1.95 ($195.00)
Minimum Value if SPY is at $225.00 = $25.00 / contract ($2,500)
Gain on Hedge = 25.00-1.95 = $23.05 / contract ($2,305)
$40,000 needed / $2,305 profit per hedge = 17.3 contracts (let’s just call it 18)
This structure creates what is called a Married Put or Protected Put position. It is not done at a 1:1 ratio (32 contracts against the 3200 shares of SPY) which is the preferred structure, but it does satisfy our needs:
Covering Just a -10% Decline in SPY
By only putting up 0.35% of our total portfolio value, or 1.7% of our remaining $200,000 in cash, we have hedged a potential -10% portfolio loss to only -5%.
WE control the outcome of the position. We can not be closed out (unless we hold the put to expiration and make no adjustments) or assigned. We bought the put, we control what happens next.
This is better protection against a sudden -10% market decline, over a -5% Stop Order or Trailing Stop that could be violated.
But, there are negatives to this approach. If SPY fell further than -10%, we could realize larger losses as we only protected 1,800 shares of our 3,200 share investment. For a little more capital we could insure all 3,200 shares. Let’s look at the ‘5-line setup’ of a full Married Put / Protected Put:
One to One Married Put for Insurance
Own 3,200 shares of SPY at $250.00 ($800,000 total)
Buy 32 cont. 20-OCT 250 puts at $1.95 (6,240.00 total)
Total Investment = $251.95 per share ($806,240.00 total)
Guaranteed Exit = -$250.00 per share ($800,000 guaranteed)
Maximum Risk = $ 1.95 per share, or 0.8% ($6,240.00)
Although this is more expensive than hedging part of the full trade:
We only use 3.1% of our remaining $200,000 capital, or 0.62% of our total portfolio value…AND the Max. Risk in any decline scenario is only 0.8% of our capital invested, even if the decline is larger than we thought.
We still control the outcome of the position, and can not be closed out early or assigned.
We have covered the full 3,200 share block with only a small percentage of our account value. We could even buy more for a higher cost and actually PROFIT to the Downside, as well!
And of course, this example relates to other size portfolios, not just a $1,000,000 account. You could apply this to a $100,000 if you were 80% invested, a $10,000 account or even a $1,000 account.
This is a much more cost effective and efficient way to protect against an expected market decline.
What are the risks? If the decline DOES NOT happen during your expected time frame you may lose the cost of insurance, $6,240, as the put would expire worthless. However, if the market continues up, you have not capped the upside gain and can still realize more profit. Which brings us to the final topic on this basic example…
Can’t I use other transactions to pay for the insurance?
Standard Collar for Insurance on SPY
We all know that trading options carries risks, just like any form of investing. Many options traders prefer to Sell Premium rather then Buy Premium. However, selling premium against a security only offers a small amount of protection, compared to buying insurance.
We could lower the cost of the insurance by selling a call against the security in this scenario. If we sold the 20-OCT 252 strike call, we could generate $1.10 in premium, cutting the cost of the insurance in half. This would create a Standard Collar position.
However, selling a call obligates us to deliver our shares at the strike ($252.00) if the stock is trading above that price. Although we cut the risk in half, we also limit the gains if we are wrong and the market continues up in price, as you can see from the Profit / Loss chart.
By selling the 20-OCT 252 strike call we lower the risk to only 0.3% of our invested capital. However, we cap the upside to only 0.5% gain, or $3,680.00 of the +$800,000 invested. This might not be a concern, as we are expecting a -10% decline in the market…but it is something to consider.
What have we covered so far?
We have looked at some of the basic ways a stock investor might consider insuring against an expected decline. Let’s rec
1. Set a -5% Stop or Trailing Stop
Pros: Free, Easy to Use
Cons: Can be violated, you do not control the outcome
2. Sell out now, Stay in Cash
Pros: Safe, effective, keep your capital
Cons: Miss further upside if decline does not happen
3. Buy the direct Inverse ETF
Pros: Simple stock purchase, don’t need options
Cons: Not cost effective at all!
4. Buy a 2X or 3X Inverse ETF
Pros: Simple purchase, don’t need options, better than standard inverse
Cons: Still not cost effective
5. Buy a Put to Insure against the decline
Pros: Leverage, lower cost, can protect the expected decline or 1:1
Cons: Requires Cost unlike a Stop…but you get what you pay for – peace of mind!
6. Create a Collar to cut down the cost of insurance
Pros: Generate premium, cut insurance cost and risk in half
Cons: Caps the upside if market continues up and no decline
But there are so many different ways to create Portfolio Insurance against a market decline. But first, we want to take a look at the proper strike selection to insure this example and using Put options to insure an actual stock portfolio!
Here is a preview of what to expect in the next few days:
Part 2: Proper ETF/Index put selection to Hedge a Real Stock Portfolio
Part 3: Other option Hedges for Stock and Options Portfolios
Part 4: Real Examples of Potential Hedges from the Past and Looking Forward
I am sure that you’ve heard Costco Wholesale (COST) announced a special dividend of $7.00 per share, plus an additional increase of $0.05 to its regular quarterly dividend.
The special $7.00 one time cash payment will be paid on May 26th, to those who are on record as owning shares on May 8th, 2017.
What do we expect to happen when a special dividend is paid? Well, we expect the COST share price to fall -$7.00 to reflect the $7.00 one time payment.
So, is this a Free Money investment if I were to buy an Out of the Money or At-the Money put option? Since the stock is going to fall the put would have to gain in price, correct? Even though I did not receive the dividend, my put would still gain and I would have a nice, juicy, leveraged profit…right?
Not quite. In fact, not at all. In addition to expecting the stock to fall 7 points when the dividend is paid, the Strike Prices of the existing options will also adjust 7 points to reflect the special payment.
For example, today, May 4th, 2017 – COST is trading at $182.36.
I could buy an At the Money 02-JUN $182.50 put at $3.45 per contract.
If COST remained at the same price, on May 8th we would expect the stock to fall to $175.36 to reflect the Special Dividend.
My 182.50 strike put would be worth $7.00 minimum in intrinsic value, so this would be a no risk +100% gain!
Unfortunately this is not the case. On May 8th my 02-JUNE 182.50 put would automatically become a 02-JUN 175.50 strike put to also compensate for the $7.00 payment.
The bid-ask of my 182.50 put the moment before the dividend is released would be equal to the bid-ask of my new 175.50 put the moment after the dividend is released.
My liquidation value just before the dividend release would be equal to my liquidation value just after the dividend is released. The gain or loss I would have on this option trade would be based on the stock performance alone from today to May 8th.
This same principle applies to a Married Put. If I purchased COST at $182.36, and at the same time bought the 02-JUN 185 put for $4.75, I would have a 5-Line Setup of:
Buy 100 shares COST at $182.36
Buy 1 02-JUN 185 put at $ 4.75
Total Invested = $187.11
Guaranteed Exit = $185.00
Maximum Risk = $ 2.11, or 1.1%
“So, when the dividend is paid, I collect $7.00 and have a guaranteed profit of $4.89 ($7.00 – $2.11), right?”
Again, no. On May 8th the stock would fall -$7.00 to compensate for the special dividend. Also on May 8th your 185 strike protective put would become a 178 strike put. The maximum loss on the position would still be $2.11, or 1.1% – even factoring in the $7.00 Special Dividend payment.
But hey, if you are long term bullish on COST, you want to take advantage of the Special Dividend AND the increased quarterly dividend over time – consider using a long term married put as outlined in the RadioActive Trading techniques for limited risk trading.
There is no free money with a Special Dividend payout, but you can still control your risk, take advantage of a bullish sentiment and further dividends with a proper limited risk structure in place.
Married Put Profits Compared to Stock Only Profits:
Using married puts to protect and insure a stock position has certain risk / reward trade-offs. Each position is a little different. Your profit results will depend on your stock selection, how much risk you take with the purchase of the put, and what income methods you apply to the position. Two different investors taking positions in the same stock will likely have different outcomes just because of their individual choices for strike price of the put, what income method to apply, and when during the hold cycle to apply the method. Recently an investor wrote to us about some profit concerns with one of his marred put positions:
“The stock DB was bought 10-4-16 using the Married Put. The stock is up 57%. I am only showing a 16% profit because of the Put. Granted Hindsight is 20/20. I realize this is a very good return in 5 months.”
This is not an unusual concern for an investor in a bull market using the married put methodology we teach in The Blueprint. The returns for a married put position will be inherently lower for a stock that rises rapidly because of the cost of the put insurance. If we knew the stock was going to rise 57% over 5 months of course it would have been more profitable not to have the married put at all. However, hindsight is 20/20 as pointed out by the investor. But. if the stock had gone down by 57% the story would have been quite different. The married put would have limited the loss to only about 4% rather than the full -57%.
In this situation, the risk adjusted gain of 16% with a maximum possible loss of 4% is a really very good return.
However, a 57% stock rise only yielding a 16% married put position return seemed odd. It has been our experience that the married put position should participate in 50% to 75% of the stock-only return. In this case we would have anticipated a 28 to 43% return for the married put position. We investigated and did a married put position position analysis to better understand the discrepancy.
What we found with Position Analysis:
I’m not going into the details of the trade and risk losing your focus on the profitability difference. Examining the details of the trade revealed some basic principals of the married put methodology that were not followed. By doing a married put position analysis we found:
The initial put position was too far in-the-money (ITM). Buying a put that was 40+% ITM, rather than less than 20% ITM, as recommended in The Blueprint, made it difficult to profit from the stock rise. Puts greater than 20% ITM create a very safe position, but if the put strike price is too high the probability of the stock reaching profitability is very low. Capital gains are sacrificed for the very high safety of the position. On the other hand, puts at-the-money (ATM) or out-of-the-money (OTM) have the potential of too much risk for the position.
We needs to balance the risk vs. reward with our choice of married puts. Our rule of thumb, as taught in The Blueprint, is a risk level of like 5-9% for the married put position. Maybe consider as much as 7-8% risk if you are bullish on the stock with good growth rates. Higher risk rates increase the profitability of a stock price rise. Higher risk for higher rewards.
A second observation that adversely effected this married put is the use of a covered call written against the stock (IM#1) for income to reduce the cost of the put insurance. The first call written expired worthless and successfully reduced the cost of the position. But a second call was written just before the stock rose significantly. When the stock rose quickly it exceeded the strike price of the call. This is a very bad condition for a married put position because you lose money on the put and become hedged out of the stock profit with the short call. It is essential to roll the strike price of the call when exceeded by the stock price. Sometimes the call strike price is exceeded because of a gap up in stock price, with little opportunity to roll immediately. In that event, consider a repair of the position outlined in this video. In this case, the second call that was written was well ITM and it reduced the potential gain for the whole position. If the second call was not written the position profits would have been over 22% instead of 16%.
Proper placement of the put combined with the correct maintenance of the second call would have resulted in a 35%+ profit as opposed to the 16% at present. A return which is closer to 60% of the gain realized by the stock alone and a figure we have generally experienced with the married put methodology of The Blueprint.
Free Options Resources: What makes options resources valuable?
Is it the promise of high returns? Is it the promise of a high success rate? Is it focusing on only the potential success of a strategy, without focusing on the risks or management?
Let’s be honest, there are thousands of free options trading resources available. Any trader who has bought one option contract or sold a call against their stock can post a blog, video or white paper about their trade. That doesn’t make them an expert on the subject matter, although they do have an experience to share.
Other free resources will give a static definition of a strategy – just enough to illustrate the basics without providing any further details on the risks of the trade or management ideas. In other words, just enough information to be dangerous.
And there are still those services that will give you just enough information to intrigue you… then promise you unrealistic returns on a strategy ‘they’ discovered that produces winners 99% of the time. We all know that if it sounds too good to be true… it probably is.
Separate the Wheat from the Chaff:
Since 1997 when I first released PowerOptions I have made it my goal to not only provide the best search and analysis tools for options investors, but to also provide the best education for real-world, self-directed options investors like you.
The PowerOptions Blog articles and archived webinars on our YouTube Channel showcase our real world experience with options trades, answers to our customers questions about options strategies and strategy education that focuses on the basics of a strategy as well as search criteria, exit strategies and trade management. Our free resources reflect my knowledge from over 35 years of options trading combined with what I have learned from my PowerOptions community of traders in the last 20 years.
PowerOptions has published over 1,000 YouTube videos on option trading, options strategies and using our patented tools. These videos are fairly popular, some videos with as many as 10,000 views per month. We add new YouTube videos about once or twice per week. It’s a good idea to subscribe to the PowerOptions YouTube Channel in order to get automatic notification when we post a new video.
Our BLOG has over 600 option trading related articles. Recently I have made a concerted effort to add more posts based on the conversations I have with investors like you every day. I think the PowerOptions YouTube Channel is a little more popular than the blog… *sigh* perhaps investors find audio/visual presentations more entertaining. But a white-paper style article can give you more time to absorb and contemplate the content.
The BLOG site and YouTube Channel allow you to ask written questions about the content by using the “comments” area. A wide variety of option trading subjects are covered in the BLOG articles and YouTube videos. Here are some blog post examples to consider:
The PowerOptions BLOG site has a powerful search engine that allows you to search by topic very easily. In the example search shown, we looked for how to achieve “Portfolio Success” and the last article listed was suggested. This article explains a portion of how I manage my personal hedge fund – all research and tracking done on PowerOptions. Just insert your search term in the top right hand search parameter box to get a list of reference articles.
In Power Options we use Big Charts as our stock charting tool. There are 3 stock chart programs offered by Big Charts:
We use the Advanced Chart version, with modifications to the default parameter settings. We modify the default settings to make the display more user friendly for the options trader. The modified settings are then saved so they will be applied to future stock chart displays without the need to change from the default setting each time a new stock chart is requested. Big Charts settings are changed in the left hand column of the chart display (in blue):
Stock chart parameter changes
The first grouping of parameters are for “Time Frame”. A one year time frame is shown by default, but for option trading 3 months is a more convenient choice. And the frequency is left in the Daily setting mode.
Indicators is the next grouping to be modified. “Moving Average” is set to SMA and the time to the right of the SMA box is set to 20. The use of the 20 day moving average compared to the actual stock price enables us to assess if the stock is in an uptrend or downtrend.
Upper Indicator is set to Bollinger Bands. These bands show the one sigma stock price range. They can be used with stock volume to assess if a new price trend is being established or just a reversion to the norm, which is the 20 day moving average. Some traders use high volume penetration of a band for initiating a long call or put trading opportunity.
Chart indicator “Lower Indicator 1” is left at Volume, which is the default setting.
“Lower Indicator 2” is set to MACD, which is an oscillator used to determine price trend also.
The “Chart Style” group is used to change the price display. We use the default settings for price and background. But change the chart size to BIG for easier reading of the display.
Under the Chart Size setting is a red Draw Chart button, click it to implement the changes.
Under the Draw Chart button there is a link called “Store Chart Settings” which will allow you to store the changes. Click “Store Chart Settings” and answer the pop up questions OK and OK. Each time a chart is call for in Power Options these new chart settings will be applied.
After changing the default settings, you will have a much more user friendly stock chart for the option trader.
Earlier today I received a call from a PowerOptions subscriber. He is the owner of a far out in time put option on MOMO and the stock was up about $0.35 in the morning (Stock MOMO, at $25.76 from $25.41 at close on FEB 14th).
The put option he purchased was the 2017-JULY 30 strike. At close on FEB 14th the bid-ask spread was listed at $6.60 to $7.20 – figure a mid-point price of about $6.90. Note: A wide bid-ask spread is not uncommon for options that are far out in time and not actively traded.
When he looked at his brokerage account this morning, it showed a value of $5.90, down -$1.00. But the stock had only moved up +$0.35. The delta of the put option was about -0.60, and increase of $0.35 in the underlying should have dropped the put price by only -$0.24.
So, what gives?
There were multiple reasons for the change, but the change was not nearly as bad as it looked…
To diagnose the issue the first thing I did was pull up the Option Chain on PowerOptions for MOMO. Looking at the July 30 strike put I saw a bid price of $6.00… and the ask was at $8.70! This would be a mid-point of $7.35 – an increase of +$0.45 from the previous days mid-point price of $6.90.
It turns out his brokerage account was showing the natural bid price for the liquidation value of the purchased put option, and not the mid-point price (had the customer been tracking this position in the PowerOptions Portfolio tools he would have seen a Current Price for his put option at $7.35 or close to the mid-point. We show the mid-point for the current prices of all options entered into the Portfolio).
There is no guarantee he could get the mid-point price if he put in an order for Selling to Close the put at $7.35, but he could definitely do better than $5.90 or $6.00.
BUT… this raised another question:
How did the put gain $0.45 in value based on the mid-point if the stock was up $0.35? It should have dropped in price, right?
A quick look at the news can often explain anomalies in option pricing.
Whenever I see something opposite of what it should be in the options world I check the News. While on the Option Chain, I clicked the Edit/More Info. Button next to the stock listing, selected Company Info/News and then selected News:
I was quickly able to see that earlier in the morning MOMO announced that it was going to report Fourth Quarter and Full Year 2016 Earnings Results on March 7th. I scrolled through some of the previous headlines briefly, but this appeared to be the only significant news on MOMO that would cause any change.
What change would Earnings cause?
We all know how sensitive stocks are to an earnings release, but options can be just as sensitive to announcements about an upcoming release.
To delve further into the issue I looked at the Implied Volatility (IV) column for the July puts on the Chain. The current values for IV were around 0.70, some just above some just below, for the 20 through 30 strikes on MOMO.
Using the Previous button on the Chain to view option data for the previous days, I saw that the previous Implied Volatility for the same options were around 0.60 (again some just above, some just below) at the close on February 14th.
The announcement of the earnings release caused the IV of the July options to move up 0.10, which would explain the increase in the July put option mid-point value, even though the stock was up in price.
I had the advantage of using the Historical Chain to look at the past data. But, even if you do not subscribe to the Historical Tools on PowerOptions you can see IV and price changes on your option in the Option Research Tool and the Option Chain. When analyzing an option simply click the Edit/More Info. Button, select Research and then Call or Put Research. At the bottom of the Options Research page you will see a graph of some basic Historical Data for the option (Bid Price, Ask Price, Volume, Open Interest, IV and a few others).
So, now we know the why and the how. With a few simple clicks we were able to see that:
Although the bid price was low, the option was not as poorly priced if we take into account the mid-point price, as shown on the Chain. The customer was definitely not down -$1.00 on the put with the stock up $0.35…unless he tried to Sell to Close the put at a market order and got filled at the worst price.
With a large change in price, or bids-ask spread we were able to quickly look at the news to see might have caused any change. The announcement of the earnings release was obviously the culprit.
With one more click from the Chain (or to the Option Research Tool) we were able to see the increase in IV (a 17% increase for 0.60 to 0.70) from the previous close to today. This explained why the bid-ask spread opened up, and why the mid-point price for the put was actually higher in price with the stock moving up.
These are some of the steps you might want to consider if you see something at the open or during the day that, well, ‘Just Doesn’t Look Right’. Or, give me a call during market hours and I will walk you through how I analyze these ‘How did X do Y when it should have done Z’ option scenarios.
Earnings are an important indicator of stock price appreciation.
In general, if you expect to earn 10% on your stock investments, the stock you choose should have their earning grow at 10% or more. Certainly there are exceptions. Buying a stock because of some short term news event, a new technology that is being developed, or a rumored merger are all exceptions. But over the long run, you should select companies for stock purchase that have a steady earnings growth so they will tend to rise in stock price in line with that earnings expectation.
When company selections are made for long stocks or married puts, we generally screen for companies that have good earnings growth. On the PowerOptions site the parameter we like to display and search by for earning growth is %EPSG. %EPSG is and abbreviation for %Earnings Per Share Growth. If %EPSG is not displayed in your search results, add that column to the report using the blue “Choose Columns” button above the search report.
To add a column, select from the search report:
Logon to PowerOptions, hover your mouse over the strategy tab for your strategy of interest and move the mouse to click Search.
Click the Choose Columns button
Click “%EPSG” under Stock Related Columns
Click “Submit and Save Columns” at the bottom right of the page
The new column added will appear on the right of the report by default, but can be moved to any position
Sort your search results by the most important data.
If you feel earnings are an important parameter for your stock purchase selections, sort the report listing using the %EPSG parameter. You should generally sort the report selections by the parameter you feel is most important to your trading strategy.